Where are the opportunities in Chinese equities?
How China's slowing growth and trade war with the US will impact clients invested in the region
China's ongoing trade war with the US has been making headlines, while concerns about its slowing economic growth continue to unnerve many investors.
But China's economy remains the second largest in the world by GDP and government stimulus may help boost economic growth this year.
So how can advisers reassure clients with exposure to the Chinese equity market in 2019, following disappointing returns in 2018?
Read on to find out more about the headwinds and tailwinds facing Chinese equities.
Advisers invest in Chinese equities despite fears
Almost half of advisers said their clients were invested in Chinese equities to "diversify" their portfolios, despite fears of a Chinese economic slowdown and growing trade tensions, according to the latest FTAdviser Talking Point poll.
The poll asked financial advisers whether their clients’ portfolios were allocated to Chinese equities and, either way, for what reason.
Some 46 per cent of advisers said their clients were invested in Chinese equities, citing "diversification".
But 23 per cent said their clients did not have an allocation to Chinese equities due to slowing growth.
As with other global markets, we believe that volatility is likely to be on the cards.
Only 14 per cent said their clients did not invest in Chinese equities because of concerns around escalating trade tensions between the US and China.
Meanwhile 17 per cent said clients had an allocation to Chinese equities in their portfolios due to its growth prospects.
Sacha Chorley, multi-asset portfolio manager at Quilter Investors, said: "China is an important part of emerging market indices so it should not be surprising that many portfolios hold some Chinese equity exposure."
Chinese equities have come under increased scrutiny by investors, amid weakening economic data and trade tensions.
China’s manufacturing sector contracted in December, with the Caixin manufacturing PMI slipping to 49.7 in the month, its lowest level since May 2017.
US tech giant Apple also issued a rare profit warning earlier this month, citing a slowdown in Chinese demand as the key reason.
Alex Shaw, director of Progeny Wealth was surprised about the poll results.
He said: "I am surprised that advisers would actively choose to invest in a market which is so opaque. While it offers low correlation to other global stock markets, transparency remains key to managing risk and reducing volatility for clients."
He added: "As with other global markets, we believe that volatility is likely to be on the cards. In the absence of full transparency, we are happy to observe from a safe distance."
Stephen Dover, head of equities at Franklin Templeton, said the US-China trade war was less about economics and more about China’s "growing political influence".
Both the US and China reached a truce last year and held two days of trade talks earlier this month.
He said: "Though the residential real estate market is a concern and economic growth has been decelerating, we do not see a 'hard landing' ahead. We believe there could be long-term opportunities in China’s more domestically-oriented sectors over the longer term."
Jean-Pierre Couture, chief economist at Hexavest, added: "The first half of the year could be a good entry point for contrarian investors because investors’ sentiment towards China is [already] depressed."
CPD: What is in store for Chinese equity investors in 2019?
Words: Victoria Tichá
Is China due a hard landing?
Chinese equities continue to face scrutiny from investors as some say optimism about the progress made in the US-China trade dispute has helped investor sentiment, while others worry a so-called ‘hard landing’ in China is imminent and portfolio exposure should be kept to a minimum.
There is no question that economic growth in China, and globally, is slowing.
Chinese GDP slowed to 6.4 per cent in the fourth quarter of 2018, the weakest quarterly growth figure since the global financial crisis in 2008, according to data from the National Bureau of Statistics of China, published on January 21.
But Michelle Qi, chief investment officer of Eastspring Investments’ wholly foreign-owned enterprise in China, says the quality and sustainability of China’s economic development, rather than the speed of its growth, should be the key focus for investors this year.
Ms Qi explains: “China doesn’t need to grow 9 or 10 per cent every year, 6 per cent is still very quick, and there's a lot more opportunity for stockpickers like ourselves – you just need to check the right sector and the right names.”
As many clients’ portfolios continue to have some Chinese equity exposure, it is important to know what key challenges and opportunities lie ahead for the market in 2019.
US-China trade spat
Amit Mehta, director for emerging markets at Hermes Investment Management, explains that over the course of 2018, China’s relationship with the US took a marked turn for the worse and the ongoing trade conflict, coupled with a slowing Chinese economy, led to a sell-off in Chinese equities in the second half of the year.
Mr Mehta explains: “But trade tensions should ease in 2019 as a compromise is reached, and a trade compromise should be good for world markets, including China’s, especially if it is accompanied by sufficient [government] stimulus to get the economy back on its 6 per cent plus growth track.”
Indeed, US President Donald Trump and Chinese President Xi Jinping set March 2 as a deadline to strike a more comprehensive agreement, after calling a truce to their trade war at the G20 summit in Buenos Aires in December 2018.
We are at the early stages of a geopolitical competition that will eventually turn more serious... than the Cold War with the Soviet Union.
Nevertheless, Mr Mehta says it is important to recognise that the US-China relationship has now fundamentally changed from one of cooperation to one of competition.
He continues: “The US has belatedly recognised that its economic ‘little brother’ has serious aspirations to global leadership, and is in the process of withdrawing many of the facilitating conventions (academia, technology, and military capability, etc) that have been in place for decades.
“We are at the early stages of a geopolitical competition that will eventually turn more serious, and infinitely more complex, than the Cold War with the Soviet Union.”
Similarly, Ms Qi says China’s economic slowdown can be attributed to “the trade dispute – not so much on earnings but rather on investor sentiment – and the second, more direct impact, China’s deleveraging campaign”.
She adds: “The deleveraging process of China’s balance sheets actually hit the economic growth quite hard from the second half of 2018, and that’s why we've seen a decline in GDP growth since – and [we expect] the bottom out will take place until the second quarter into the third quarter this year.”
The trade spat comes at an especially difficult time for the Chinese economy, suggests Claudia Calich, manager of the M&G Emerging Markets Bond fund.
Ms Calich notes: “As the cost-benefit of additional policy stimulus is lower than it was a decade ago, given the higher leverage in the system – inflation is good to cut debt but comes at a very high competitiveness cost.”
Despite the negative headlines, she warns investors should not rule out any potential positive tailwind, as the US-China relationship could stabilise and have a positive impact on asset prices, including emerging market debt.
However, Philip Hanley, director and independent financial adviser at Philip James Financial Services, believes “the news of China’s financial death has been greatly exaggerated”.
Mr Hanley suggests: “All will be well until the next ‘crisis’ in a couple of years from which lots of people, mainly in China, will make lots of money.
“It’s a dictatorship, they can do and tell us they’re doing whatever they want.”
Despite his reservations, Mr Hanley says he invests in model portfolios and multi-asset funds and would expect most portfolio managers to maintain exposure to “one of the world’s largest economies”.
It is unsurprising that headline growth is slowing, with the ongoing rebalancing of the economy towards services.
While Dennis Hall, chief executive and chartered financial planner at Yellowtail Financial Planning, warns investors should approach with a little more caution, as the level of debt in China draws some parallels to Japan in the early 1990s.
He asks: “Why would you want to get involved, other than through a global equity fund which would ensure you’re not going overweight, and which would give better exposure to companies already benefiting from China through trade?”
Outlook for 2019
The Chinese economy is now on a par with the US as a key driver of global financial markets, and investors need to follow it closely, suggests James Dowey, chief investment officer and chief economist at Neptune Investment Management.
Mr Dowey adds: “Allocation wise, despite China’s economic ascendency, I’m sceptical that Chinese stocks will prove as reliable a mechanism as US stocks to grow one’s wealth over the long term.
“The problem is that shareholders are possibly just not powerful enough in China to win so big a share of the proceeds of long-run economic growth, so I believe one should temper one’s allocation to Chinese stocks to take account of this problem.”
But Danny Dolan, managing director of China Post Global, believes that despite the slowdown, China’s growth continues to strongly outperform other major markets.
“It is unsurprising that headline growth is slowing, with the ongoing rebalancing of the economy towards services, and tightening fiscal policy, credit conditions and financial supervision,” he observes.
He also believes setting a lower growth target for 2019 – between 6 per cent to 6.5 per cent – as well as China’s recent stimulus plans, in light of slowing growth and the ongoing US tariff dispute, was the right move by Chinese authorities.
China is now the second largest economy in the world and the largest contributor to global GDP growth.
Mr Amit predicts GDP growth will slow to 6.2 per cent, because “given likely tariff increases and residual effects from the slowdown in shadow lending and municipal property sales, a mid to high single-digit growth is realistic”.
He also suggests the Chinese economy “normally responds well to government stimulus”, and this time should be no exception.
“This may be one of the last times, however, that the government can use this trick as the country’s level of debt is high, its level of technology is low, and its political system is sclerotic,” Mr Amit notes.
“With all this in mind, we believe the equity market in China is undervalued, and is, over the medium term, quite capable of performing strongly.”
Roger Jones, head of equities at London & Capital, disagrees and explains that investing in a Chinese equity fund, as opposed to a global equity fund, could be a good idea in the short term.
Mr Jones explains: “Short-term support for Chinese equities is not hard to find, with low valuations, improving trading war relations and the recent government stimulus likely to boost or support GDP growth.”
Mr Jones continues: “Chinese equity returns have varied dramatically from global equities over the last few years and global equities are very US stock market dominated.
“[But] China is now the second largest economy in the world and the largest contributor to global GDP growth.”
Eastspring Investments’ Ms Qi says, looking at historical valuations, China A-shares also look cheap.
She notes that foreign ownership of China A-shares is already about 6.5 per cent, and this could go up as a result of the inclusion of China A-shares in the MSCI Global indices in 2018.
Nevertheless, she warns: “While it’s an opportunity for any China manager, the important thing is to talk to an onshore manager who lives in China, who talks to Chinese companies and grows with them every day.
“We prefer to look at industry leaders who will benefit from strong market pricing power, the recent supply-side reforms and increased deleveraging, and also higher environmental standards.”
Separately, she notes: “While a trade war is negative on the import and export sector, it has been positive in the way it pushed the government to think about changing to domestic-driven income policy – China can grow quite strongly based on domestic demands.”
While the outlook at the start of 2019 has proved to be more positive, Adrian Lowcock, head of personal investing at Willis Owen, says: “Going forward will be about managing expectations and avoiding panic, valuations, falling markets etc, more than anything else.”
Mr Lowcock identifies three Chinese equity funds to watch in 2019:
- First State Greater China Growth fund
- Fidelity China Focus fund
- Janus Henderson China Opportunities fund
He also signposts two sectors investors in China should keep an eye on in particular, including technology and insurance.
Mr Lowcock explains: “There are concerns over regulation of technology. However, in China, the state is all and personal liberties are less of a concern, so regulation is likely to be less onerous in Chinese technology companies.”
He adds: “The country has also invested heavily in developing expertise in these areas and that sort of investment, and the momentum it creates doesn’t turn off overnight.”
House View: Outlook 2019 - China equities
Following a cyclical recovery in 2017, driven by robust domestic demand and supply-side reforms, the emphasis in China has since shifted to the quality of economic growth.
With political power consolidated under President Xi Jinping, this focus on quality growth as well as economic and social stability brought renewed efforts to shrink the shadow banking sector. The government’s effort to deleverage the economy and increase regulatory oversight led to concerns around economic growth coming into 2018.
Indeed, we saw credit conditions tighten on the back of reduced shadow banking activity. Tighter credit led to a rise in credit defaults this year, while areas, including industrial production and fixed asset investment, also lost momentum.
Against the backdrop of a slowing economy and escalating trade tensions with the US, China has introduced various measures to help support the economy:
- The delayed implementation of regulations on wealth management products.
- Cuts in banks’ reserve requirement ratio (RRR).
- The accelerating issuance of local government bonds.
- The encouragement of banks to increase lending to small and medium enterprises.
- The State Council’s guideline to support domestic consumption.
- Changes to the income tax scheme for individuals.
We believe that these policies are aimed at cushioning the economy on the downside rather than providing large scale stimulus. A weak renminbi and high debt levels also limit the ability of the government to stimulate aggressively.
The government will need to continue to balance its agenda for deleveraging and introducing structural reforms, whilst maintaining reasonable economic growth.
On the trade front, our base case remains that a wide-ranging destructive trade war is not in anyone’s interest.
The risk to Chinese and Asian earnings remains hard to gauge given the announced tariffs to date are relatively narrow in scope and will have little impact on the listed corporate sector.
We see limited scope for Chinese manufacturing to be re-shored to the US, or substitution of US goods in place of Asian imports. However, it is the second order impact on capex and investments, and potentially on consumption, that is harder to measure.
China is unlikely to move on its strategic vision to transform itself into a technology leader.
The renminbi is an unlikely tool should trade tensions continue to escalate given the risks of inciting capital flight, but currency weakness may be seen as a result of US dollar strength.
The risks of a full-scale and protracted trade war are longer term in nature, with China’s strategic industrial policy blueprint and a Sino-US technology arms-race at the heart of the issue.
China has shown its willingness to negotiate and compromise on trade issues to narrow the trade deficit, reduce import barriers and further liberalise its domestic market. However, China is unlikely to move on its strategic vision to transform itself into a technology leader.
Defensive stance, though value is emerging
Earnings-per-share growth is currently forecast to be in the mid-teens, but we think that is likely to moderate going into 2019.
Margin pressure for mid-stream consumer and industrial companies remains high, especially for those who are unable to pass on higher costs.
Valuations for China equities have become more attractive and suggest upside for investors over the medium term.
We remain relatively defensively positioned going into next year given the current environment, with most of our exposure concentrated in domestically-focused names and sectors showing long-term growth trends.
We remain underweight to technology stocks given uncertainties brought about by regulatory headwinds.
We prefer the energy sector given discipline on the supply side and on pricing. We also favour Chinese insurance companies, and names benefiting from domestic consumption, where we are seeing a pick-up in offline consumer activity.
Valuations for China equities have become more attractive and suggest upside for investors over the medium term.
However, investors are likely to remain cautious in the near term given the likelihood of further cuts in earnings forecasts, continued uncertainty on the trade front, and continued increases in US interest rates in the next few months.
As bottom-up investors, our focus remains on those businesses best equipped to navigate the current slowdown and also exploit the favourable longer-term trends we continue to see in the market.
Louisa Lo is head of Greater China equities at Schroders